TRADER'S NOTEBOOK

Do The Math The RSI Way

12/08/14 01:54:19 PM PSTby Ron WalkerEven though there are scores of indicators, the relative strength index and the divergence still work.

Your trading system may be based on candlesticks, chart patterns, Elliott waves, Fibonacci retracements, indicators, trends, support and resistance, or any combination of these technical methods. But there is one trading technique that can be used in conjunction with all of these systems, and that is a divergence with reference to the relative strength index (RSI).

RSI DIVERGENCES If truth be known, there are a lot of misconceptions about divergences. John Hayden, in his book RSI: The Complete Guide, lays out the framework of the RSI and the classifications of divergences. The divergences that form on the RSI are classified into three types: simple divergence, hidden divergence, and multiple long-term divergence.

Hayden writes, "A bullish divergence only appears when the existing trend is down. If the trend is clearly down, why are we even thinking of buying? Wouldn't it be more prudent to be looking for a place to get short?"

SIMPLE DIVERGENCE A simple divergence is a single divergence that occurs in either an uptrend or a downtrend. In the case of positive divergence, it tells us that the bears are exhausted and that prices will likely rise for the short term. A simple negative divergence is an indication that prices have moved up too quickly and need time to either consolidate or give back some of the advance in the form of a retracement. But once any simple divergence runs its course in the form of a contratrend, the previous dominant trend is likely to reassert itself.

HIDDEN DIVERGENCE Hidden divergence is less common and sometimes makes an appearance after a simple divergence is made. Hidden divergence is a point of divergence that is camouflaged on the RSI to the untrained eye. It is the strongest form of divergence for short-term swings, and thus the most valuable to swing and daytraders.

MULTIPLE LONG-TERM DIVERGENCE It takes multiple points of divergence (at least three) from an initial reference point on the RSI to change a trend. So if a stock were in a downtrend, it would take multiple points of higher RSI divergences from a particular point of reference in order to successfully alter the current downtrend.

As Hayden points out, when "there are three bullish divergences where the price has made three consecutive lower lows while the RSI has made three consecutive higher lows, these higher bullish divergences would be classified as multiple long-term divergences." These multiple points of divergence over a long-term period will ultimately initiate a change in trend. Those trading in an intraday time frame obviously will see multiple long-term divergences more frequently than those trading in a daily time frame.

In Figure 1, all of these divergences made an appearance on the 10-minute chart of the Standard & Poor's 500 during the advance from February 22, 2008, until the reversal on February 28, 2008.

FIGURE 1: S&P 500 10-MINUTE CHART. In the early stages of the advance, simple negative divergence and hidden negative divergence provided short-term buying opportunities as the advance momentarily paused. Once prices produced a higher low, the advance resumed. It wasn't until multiple points of long-term negative divergence made its appearance that led to the demise of the rising trend.

RSI RATIOS AND MATH So in the case of a simple divergence, a contratrend in a bear rally may find resistance as it approaches the value of 60. As Hayden points out, downtrends find resistance in the 60 to 66.67 range on the RSI and support near the value of 20, while an RSI uptrend finds support at 33.33 level and resistance at 80. However, these guidelines are not set in stone, and there are exceptions to the rule, but for the most part RSI shouldn't steer too far away from these parameters. There will be times that the indicator varies away from these principles moving into extreme levels from time to time.

Both 66.67 and 33.33 have Fibonacci roots and are turning points in calculating the average gain and loss ratio. Hayden notes the importance of the resistance at 66.67 as a pivot point when the relationship between the gain average and loss average ratio changes. Hayden applies RSI math to calculate ratios. From the value of 50 to 66.66, the average gain and loss ratio remains at 1:1, reflecting an equality of up and down days. But as the RSI moves closer to the value of 66.67, the amount of up days is steadily increasing. Once the 66.67 level is reached, the ratio increases by 2:1, meaning that the up average is twice the amount of the down average.

Therefore, once the RSI reaches 66.67, the probability of further upside momentum intensifies. Just the opposite is true when the RSI reaches 33.33. When the value of 33.33 is reached, it signals that there has been a shift in the balance of up and down days to the downside. The change in the ratio from 1:1 to 1:2 marks a precise reference point in time, where the momentum shifts in favor of the bears.

PRACTICAL USE OF THE RSI In Figure 2, the 10-minute chart of the Standard & Poor's 500 broke down from its rising price channel at approximately 2 pm Eastern time on February 27, 2008. Ironically, the next morning the breakdown was accompanied by a decline in the value of the RSI falling below the value of 33.33, which is plotted using a 14-period time interval. After the initial breaking of the trendline and a successful backtest, prices had a lower high in place. Then at the open of the next trading session on February 28, the RSI fell below 33.33 to 32.74, as prices produced a lower low confirming the new trend.

FIGURE 2: S&P 500, 10-MINUTE CHART. The 10-minute traders of the S&P 500 received an early sell signal on February 27, 2008. Shortly before the close, prices broke below the rising trendline. The next morning the RSI confirmed the breakdown, falling below the value of 33.33. The minor downtrend was tested for a third time. From there prices collapsed, developing a new accelerated declining trendline. During the accelerated declining trend, the RSI never rose above the value of 60.

An attempt was made to test the new declining minor trendline that same day, but the recovery was quickly halted by the bears as the RSI reached the value of 60. The bears wouldn't let the recovery rise higher than an RSI reading of 60.18. Parenthetically, prices came to a screeching halt at the declining trendline once the RSI reached 60.18. Both RSI 60 and the declining trendline served as resistance. Further deterioration occurred for the next three trading sessions that caused an accelerated declining trendline to occur, which resulted in a divergence between price and the RSI. Near the end of the session on March 4, prices managed to break above the accelerated declining trendline after multiple long-term points of positive divergence formed on the RSI. This allowed a contratrend to rise back to the 1340 area, where it stalled the next day at the original downward trendline. The contratrend was thwarted as the more dominant trend reemerged, suppressing the longs in their attempt to drive prices higher.

During this particular contratrend, the RSI managed to rise above the values of 66.67 and 70 for a brief moment to 73.45. But the endeavor to change the long-term trend failed when prices didn't confirm the RSI breakout. Prices spiked up above the declining trendline for a moment, immediately after the RSI reached 73.45, but there was no decisive follow-through. Therefore, another breakout attempt was blocked, sending prices lower. Hayden found that most "contratrend rallies do not exceed 50% of the previous decline," which was the case on the 10-minute chart of the S&P 500.

Ron Walker is an active trader and technician. He operates an education website dedicated to the study of technical analysis. The website offers free market analysis with daily video presentations and commentaries. He may be reached through his website at thechartpattern.com or via thechartpattern@gmail.com.